Investors have very few choices when it comes to getting direct exposure to inflation movements. Martin Kremenstein explains how the newly launched PowerShares DB US Inflation Exchange Traded Notes and PowerShares DB US Deflation Exchange Traded Notes provide a direct exposure to both rising inflation and falling inflation.

Q: How has the idea of inflation-linked Exchange Traded Notes evolved?

A : The genesis of these products comes out of the rates world.

At Deutsche Bank, we see a lot of institutional investors, such as insurance companies or pension funds, that want TIPS break-even products to manage long-term inflation exposures.

The traditional way of getting inflation protection is through the Treasury Inflation Protected Securities (TIPS). However, because long-term interest rates tend to increase when inflation rises and fall when inflation is subdued, over the years TIPS have not always reflected inflation accurately and have a low correlation to inflation.

We have designed these notes in a way that it strips off the interest rate earned from the Treasury and allows investors to have direct exposure to the inflation as measured by the consumer price index.

In fact, a long or short only position in TIPS may not be an appropriate hedge against inflation. TIPS are essentially fixed-rate Treasuries overlaid with inflation exposure; therefore prices at issuance are sensitive to both inflation and market interest rates. By eliminating interest rate exposure, we believe that an investor will find it easier to target long or short exposure to inflation expectations through the inflation and deflation ETNs.

We introduced two ETNs, the long TIPS break-even and the short TIPS break-even. The long ETN enables investors to profit in the event of inflation while the short ETN enables investors to profit in the event of deflation.

In effect, The PowerShares DB US Inflation Exchange Traded Notes (INFL) and The PowerShares DB US Deflation Exchange Traded Notes (DEFL) are the first exchange-traded products to provide investors with direct exposure to U.S. inflation or deflation expectations.

These ETNs give investors the opportunity to take long or short exposure to changes in the market’s expectations of future inflation implied by the difference in yields between a notional long or short position in the U.S. Treasury Inflation Protected Securities and an offsetting notional position in U.S. Treasury Bonds with approximately equivalent terms to maturity.

Q: What are the core characteristics of the two ETN products?

A : The two products, launched on December 6, each have a long and short component. INFL, the long inflation ETN, goes long TIPS and short Treasury futures in order to strip out the duration from the TIPS leaving just the inflation aspect of TIPS.

DEFL is the opposite. It is the short TIPS and long Treasury futures, and in order to strip out the short duration we short the inflation component.

These ETNs are based on the DBIQ Duration-Adjusted Inflation Index and the DBIQ Duration-Adjusted Deflation Index respectively, which are intended to capture up or down movements in the U.S. inflation or deflation expectations.

Consequently, to gain exposure to the market's expectation that future inflation will increase, the INFL takes a notional long position in TIPS and a notional short position in U.S. Treasury bonds with approximate equivalent terms to maturity.

To gain exposure to the market's expectation that future inflation will decrease, the deflation ETN takes a notional short position in TIPS and a notional long position in U.S. Treasury bonds with approximately equivalent terms to maturity.

Q: How closely will the products follow the underlying indexes?

A : A feature of all ETNs is that they are tied to an index performance rather than attempting to track an index by replicating the strategy. This means that the ETNs will track the index, less the management fee. INFL and DEFL are linked to the DBIQ Duration-Adjusted Inflation Index and the DBIQ Duration-Adjusted Deflation Index, DB indices that are published on a daily basis and updated every 15 seconds.

The ETNs will move in lock step with the index, moving 10 cents for every 1 unit move in the index.

Q: Are there any prerequisites for accessing these products?

A : These ETNs are listed on NYSE Arca, and they are available to retail investors to take advantage of markets based on their views or expectations of the future inflation direction.

Q: How are these ETNs designed?

A : These products are designed to trade flat if interest rates move and inflation expectations do not change because the interest rate component has been offset, but the ETN is designed to move when the CPI expectations change.

INFL attempts to isolate inflation by going long U.S. Treasury Inflation Protected Securities and short U.S. Treasuries. U.S. TIPS are U.S. Treasuries with a fixed coupon rate whose principal is adjusted for changes to the Consumer Price Index. By going long U.S. TIPS and shorting U.S. Treasuries, we believe an investor can effectively hedge interest rate risk exposure inherent in TIPS and thus gain long exposure to changes in inflation.

In a similar fashion, the deflation ETN attempts to gain short exposure to changes in U.S. inflation by going long U.S Treasuries and short U.S. TIPS.